How Tax Reform Can Bolster Americans’ Shrinking Saving

With pandemic-era savings now fully depleted and the majority of Americans pointing to their finances as their biggest source of stress, one thing is clear: the US needs policies that help people save more.

Individual saving provides financial security and fuels economic growth through investment. Unfortunately, our current system double taxes saving, encouraging people to spend now rather than save for later.

Understanding how the current tax code treats saving can help us explore potential reform options to better encourage Americans to save.

How Does the Tax Code Treat Saving?

The tax code treats saving in four different ways: (1) taxing principal (the initial amount of money you save) and returns (the interest or gains you earn on your savings), (2) not taxing principal but taxing returns, (3) taxing principal but not returns, or (4) not taxing at all.

Most types of saving are taxed on both principal and returns. If you put your after-tax incomeAfter-tax income is the net amount of income available to invest, save, or consume after federal, state, and withholding taxes have been applied—your disposable income. Companies and, to a lesser extent, individuals, make economic decisions in light of how they can best maximize their earnings.
into a savings account at your bank (that’s your principal) and then earn interest (that’s your return), you’ll pay taxes again on the return to your saving.

The tax code offers a few different exceptions to this rule, usually by providing a deduction for your saving up front (which removes the tax on principal) or not taxing the return on your saving.

For example, contributions to a Roth individual retirement account (IRA) cannot be deducted for tax purposes and will be taxed when you contribute. But later in retirement, when you make withdrawals from the account, you won’t pay any taxes on the principal amount or the investment earnings. Traditional IRAs, on the other hand, are the reverse, allowing you to deduct contributions now but taxing your withdrawals later. Only a few types of saving, like healthcare savings accounts, face no layers of tax.

Why Should We Encourage Saving?

Our current system double taxes saving. We pay income taxes before we deposit our money into a savings account, and then we’re taxed again on the interest we earn from our saving. In other words, the same dollar of saving gets taxed twice.

In fact, in some cases, one dollar of income can face up to four layers of tax: initially when you earn it and pay income taxes, when businesses you invest in earn profits and pay business income taxes, when you realize returns to your investment and pay taxes on capital gains and dividends, and when you pass away or give it as a gift through estate and gift taxes.

Multiple layers of tax make saving less profitable, which encourages spending it now over saving for the future. Discouraging saving contributes to poor financial health and hurts investment and growth.

The table below shows how taxing income when it is first earned and then again after it is saved places a higher percentage tax on income you save compared to income you spend right away.

Removing double taxationDouble taxation is when taxes are paid twice on the same dollar of income, regardless of whether that’s corporate or individual income.
would treat saving and consumption neutrally, removing the influence of taxes from the decision over whether to spend now or save and spend later. In turn, increased saving leads to more investment fueled by that saving, much of it done in the US, growing incomes while bolstering financial security.

Within our current income tax system, only certain types of saving qualify for neutral tax treatment, like saving for retirement. Even then, these types of savings accounts are subject to many rules, regulations, and limitations.

Universal savings accounts (USAs), however, would be similar to your traditional or Roth IRA but would be relatively free of rules and limitations. Any individual could contribute up to the maximum amount each year to save for anything, from an unexpected expense to a down payment on a starter home.

Universal savings accounts are one option to consider to make saving simple, easy, and more attractive for Americans.

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